Question

Assume that the spot exchange rate is 1.38 USD/GBP, while interest rates are 3.2% in the US and 2.5% in the UK.

a. According to international parity conditions, what is the expected 6-month forward exchange rate?

b. You believe that political conditions are such that the GBP will lose value in the coming six months. What position should you take in the forward market?

c. If you take the position chosen in part B and the spot rate in six months is 1.40 USD/GBP, how much money would you have made or lost (in USD) based on a notional investment of GBP 2.5 million?

Answer 1

a.As per parity conditions, forward exchange rate = spot rate(1+interest rate USD)/(1+Interest rate GBP)

=1.38(1+0.032*6/12)/(1+0.025*6/12)

= 1.40208/1.0125

=$1.3848/GBP

B.It is expected that GBP will lose value in the coming six months, long position i.e. buying position for GBP should be taken in forward market since lower dollars will be required to buy GBP in the forward market

C.Selling Price = 1.40 USD/GBP

Hence, profit made = (1.40-1.3848)*2,500,000

=$38,000